03/31/2011

David Sokol, widely seen as the leading contender to succeed billionaire Warren Buffett at the helm of Berkshire Hathaway Inc., defended himself Thursday morning after resigning unexpectedly amid surprising revelations about his personal stock trading.

In an unusual and personal announcement Wednesday evening, Mr. Buffett said the resignation followed revelations that Mr. Sokol had purchased roughly $10 million in shares of a chemicals company that Berkshire recently agreed to buy at the suggestion of Mr. Sokol, Lubrizol Corp.

"I don't believe I did anything wrong," Mr. Sokol said in an interview on CNBC. "I don't think you can ask executives not to invest their own families' capital." ...

Mr. Buffett said Mr. Sokol, 54 years old, had bought 96,060 shares in January, before Berkshire reached a $9 billion deal to acquire the company. Berkshire's purchase price of $135 per share meant that Mr. Sokol's stake rose $3 million in value. ...

Securities lawyers debated whether Mr. Sokol's dealings could fall into a gray legal area. In broad terms, insider trading laws prohibit individuals from trading on shares based on material nonpublic information in violation of some duty of trust.

One key question, lawyers say, is whether Mr. Sokol knew that he would pitch a Lubrizol deal to Mr. Buffett, or even that he might do so, at the time he bought Lubrizol shares. If Mr. Sokol did know at that time, that could suggest he had material information at the time he bought the shares, lawyers said.

However, lawyers said it could be hard to show that Mr. Sokol misappropriated information in breach of a duty to Berkshire. A question would be whether in buying shares he wrongly used knowledge about what Berkshire was likely to do.

It's hard to see how what Sokol did qualifies as insider trading under SEC Rule 10b-5. The classic disclose or abstain theory doesn't apply because Sokol didn't trade in the stock of the company of which he is an insider. So you'd have to rely on the misappropriation theory. The trouble here is that the SCOTUS in US v. O'Hagan made clear that liability is premised on the use of “confidential information for securities trading purposes, in breach of a duty owed to the source of the information.” Under this theory, the majority explained, “a fiduciary’s undisclosed, self-serving use of a principal’s information to purchase or sell securities, in breach of a duty of loyalty and confidentiality, defrauds the principal of the exclusive use of that information.” If Sokol traded before Berkshire made any decisions, did he really trade on the base of confidential information belonging to Berkshire-Hathaway? In effect, he traded on the basis of what he knew that HE intended to do. Even though he's an agent of Berkshire, I'm not sure trading on the basis of the knowledge that he was going to pitch a takeover to his boss counts as inside information.

Sokol may have had material information when he bought his second batch of shares: i.e., that he was going to pitch the company to Buffett. Although he didn’t know whether Buffett would go for it, a company’s just being pitched to Buffett by a trusted insider likely increases its value. [Update: See Sorkin: "though he had no control over Mr. Buffett’s ultimate decision, he was one of a select few who were in a position to influence such a transaction."]

But did Sokol breach a duty to Berkshire? The company policy says employees should ask “themselves whether they are willing to have any contemplated act appear the next day on the front page of their local paper—to be read by their spouses, children and friends—with the reporting done by an informed and critical reporter.”

On the other hand, Buffett knew. On the third hand, did Buffett know the extent of Sokol’s ownership, or the fact that he bought the shares knowing of Berkshire’s possible interest? On the fourth hand, it seems highly unlikely Sokol thought he was doing anything wrong.

Berkshire might be hurt if Sokol had a conflict of interest in pitching the deal. But that conflict was disclosed.

OTOH, just the day before Larry had praised Judge Posner's recent decision holding that "disclosure of the conflict was not enough to eliminate the breach of fiduciary duty issue." As Posner wrote:

To have a conflict and to be motivated by it to breach a duty of loyalty are two different things—the first a factor increasing the likelihood of a wrong, the second the wrong itself. Thus a disloyal act is actionable even when a conflict of interest is not—one difference being that the conflict is disclosed, the disloyal act is not.

What might be the disloyal act? I'm thinking that In re eBay, Inc. Shareholders Litigation, 2004 WL 253521 (Del. Ch. 2004), may come into play here. During the late 1990s, a phenomenon known as spinning became common. In return for hiring a given investment bank to do their firm’s work, executives of that firm would receive preferential allocations of shares being sold in an IPO by another client of that investment bank. The executives would then sell those shares almost immediately, typically at a much higher price than then IPO sale price. Spinning thus apparently accounted for at least some of the persistent problem of under-pricing of IPO stocks.

The individual defendants here were executives of eBay who spun shares sold to them by Goldman Sachs. Plaintiffs are shareholders of eBay, suing derivatively. Plaintiffs advance the clever argument that the executives usurped a corporate opportunity from eBay.

Did Sokol's buying up shares in Lubrizol likewise usurp an opportunity he should have left on the plate for Berkshire-Hathaway? I think it would be a very aggressive application of the doctrine. But in the course of his opinion Chancellor Chandler further explained that "even if one assumes that IPO allocations like those in question here do not constitute a corporate opportunity, a cognizable claim is nevertheless stated on the common law ground that an agent is under a duty to account for profits obtained personally in connection with transactions related to his or her company." Granted, making a profit on inside information differs from the kickbacks at issue in eBay, but doesn't prompting your firm to buy a company in which you've invested similarly invoke fiduciary obligations?

In Brophy, the defendant insider traded on the basis of information about a stock repurchase program the corporation was about to undertake. Stephen M. Bainbridge, Securities Law: Insider Trading 20-21 (2d ed. 2007). In a very real sense, the insider was competing with the corporation, which both agency law and corporate law clearly proscribe. Indeed, the insider’s conduct in fact directly threatened the corporation’s interests. If his purchases caused a rise in the stock price, the corporation would be injured by having to pay more for its own purchases. A derivative suit seeking redress for that potential injury thus was quite proper.

In Toll, the Court defined a Brophy claim as follows:

“[A] plaintiff seeking to prevail on a Brophy claim ultimately must show that: 1) the corporate fiduciary possessed material, nonpublic company information; and 2) the corporate fiduciary used that information improperly by making trades because she was motivated, in whole or in part, by the substance of that information.” In re Oracle Corp., 867 A.2d 904, 934 (Del. Ch. 2004) (hereinafter “Oracle”), aff’d, 872 A.2d 960 (Del. 2005) (TABLE).

Toll, slip op. at 16.

If Sokol's trades drove up the price of Lubrizol, perhaps a Delaware court would extend Brophy to misappropriation cases? Indeed, a Delaware court might not even require a showing that the trades effected the price of Lubrizol stock. The Toll Court explained that:

In the typical scenario in which an insider trades based on material information that allegedly was not disclosed to stockholders, a corporation can recover for actual harm causally related (in both the actual and proximate sense) to the breach of the duty of loyalty. Without limiting the types of harm that could be related causally to a loyalty breach, the obvious candidates are costs and expenses for regulatory proceedings and internal investigations, fees paid to counsel and other professionals, fines paid to regulators, and judgments in litigation.

What all this shows, I think, is that the case stretches the boundary of insider trading liability. The misappropriation theory requires that you use information that belongs to the principal. Could one construct an argument based on corporate opportunities, agency law, Brophy and Toll that Sokol's information belonged to Berkshire-Hathaway? I've tried to play around with that in the preceding paragraphs, but I remain unpersuaded that there is a violation of federal law here.

Finally, Larry asks:

My question: what should federal law have to do with all this? The “hook” for federal securities liability is the trading in Lubrizol — but the breach of duty that triggers liability has to do with the details of Sokol’s dealings with Buffett and Berkshire. This, as I’ve said before, is appropriately a matter of state law. See my article, Federalism and Insider Trading, 6 Supreme Court Economic Review, 123 (1998).

A fair question, but one that I think has a good answer. I addressed this point at length (pp. 39-45, 83-84) of The Law and Economics of Insider Trading: A Comprehensive Primer, and even more length in Incorporating State Law Fiduciary Duties into the Federal Insider Trading Prohibition, 52 Washington and Lee Law Review 1189 (1995).

I argue that insider trading is not defined in the federal securities statutes. Instead, its definition has evolved through a process of common-law adjudication. At the core of the resulting rule is a requirement that the alleged inside trade constitute a breach of the trader's fiduciary duty to refrain from self-dealing in confidential information. Once the substantive definition of insider trading is viewed as a species of federal common law, the question arises whether federal courts should incorporate state law as the rule of decision or create a unique federal standard. I demonstrate that the insider trading prohibition can be justified only as a mechanism for protecting property rights in information. As such, the prohibition has relatively little to do with the traditional securities regulation concerns of disclosure and fraud. To the contrary, insider trading became a matter of federal concern because of the SEC's self-interest and that of some of its regulatory constituents. To be sure, the exigencies of detecting and prosecuting insider trading warrant a continuing federal regulatory role. Because there is no significant federal policy interest at stake, however, there is no reason to create a unique federal rule defining insider trading. Instead, courts should adopt state law fiduciary duty principles as the rule of decision.

Granted, reliance on state law will complicate insider trading prosecutions. But no more so than in any other case where state standards are incorporated into federal common law. In any case, there are affirmative reasons to adopt state law as the rule of decision. By acknowledging that insider trading is primarily a matter for state law, like all other questions of fiduciary duty, this approach accords proper deference to the states' position as the primary regulator of corporate governance questions. Finally, because state law fiduciary duty rules are designed to protect property rights, looking to them to define insider trading will more clearly tie the prohibition to the rationale for regulating insider trading.

Comments

David Sokol, widely seen as the leading contender to succeed billionaire Warren Buffett at the helm of Berkshire Hathaway Inc., defended himself Thursday morning after resigning unexpectedly amid surprising revelations about his personal stock trading.

In an unusual and personal announcement Wednesday evening, Mr. Buffett said the resignation followed revelations that Mr. Sokol had purchased roughly $10 million in shares of a chemicals company that Berkshire recently agreed to buy at the suggestion of Mr. Sokol, Lubrizol Corp.

"I don't believe I did anything wrong," Mr. Sokol said in an interview on CNBC. "I don't think you can ask executives not to invest their own families' capital." ...

Mr. Buffett said Mr. Sokol, 54 years old, had bought 96,060 shares in January, before Berkshire reached a $9 billion deal to acquire the company. Berkshire's purchase price of $135 per share meant that Mr. Sokol's stake rose $3 million in value. ...

Securities lawyers debated whether Mr. Sokol's dealings could fall into a gray legal area. In broad terms, insider trading laws prohibit individuals from trading on shares based on material nonpublic information in violation of some duty of trust.

One key question, lawyers say, is whether Mr. Sokol knew that he would pitch a Lubrizol deal to Mr. Buffett, or even that he might do so, at the time he bought Lubrizol shares. If Mr. Sokol did know at that time, that could suggest he had material information at the time he bought the shares, lawyers said.

However, lawyers said it could be hard to show that Mr. Sokol misappropriated information in breach of a duty to Berkshire. A question would be whether in buying shares he wrongly used knowledge about what Berkshire was likely to do.

It's hard to see how what Sokol did qualifies as insider trading under SEC Rule 10b-5. The classic disclose or abstain theory doesn't apply because Sokol didn't trade in the stock of the company of which he is an insider. So you'd have to rely on the misappropriation theory. The trouble here is that the SCOTUS in US v. O'Hagan made clear that liability is premised on the use of “confidential information for securities trading purposes, in breach of a duty owed to the source of the information.” Under this theory, the majority explained, “a fiduciary’s undisclosed, self-serving use of a principal’s information to purchase or sell securities, in breach of a duty of loyalty and confidentiality, defrauds the principal of the exclusive use of that information.” If Sokol traded before Berkshire made any decisions, did he really trade on the base of confidential information belonging to Berkshire-Hathaway? In effect, he traded on the basis of what he knew that HE intended to do. Even though he's an agent of Berkshire, I'm not sure trading on the basis of the knowledge that he was going to pitch a takeover to his boss counts as inside information.

Sokol may have had material information when he bought his second batch of shares: i.e., that he was going to pitch the company to Buffett. Although he didn’t know whether Buffett would go for it, a company’s just being pitched to Buffett by a trusted insider likely increases its value. [Update: See Sorkin: "though he had no control over Mr. Buffett’s ultimate decision, he was one of a select few who were in a position to influence such a transaction."]

But did Sokol breach a duty to Berkshire? The company policy says employees should ask “themselves whether they are willing to have any contemplated act appear the next day on the front page of their local paper—to be read by their spouses, children and friends—with the reporting done by an informed and critical reporter.”

On the other hand, Buffett knew. On the third hand, did Buffett know the extent of Sokol’s ownership, or the fact that he bought the shares knowing of Berkshire’s possible interest? On the fourth hand, it seems highly unlikely Sokol thought he was doing anything wrong.

Berkshire might be hurt if Sokol had a conflict of interest in pitching the deal. But that conflict was disclosed.

OTOH, just the day before Larry had praised Judge Posner's recent decision holding that "disclosure of the conflict was not enough to eliminate the breach of fiduciary duty issue." As Posner wrote:

To have a conflict and to be motivated by it to breach a duty of loyalty are two different things—the first a factor increasing the likelihood of a wrong, the second the wrong itself. Thus a disloyal act is actionable even when a conflict of interest is not—one difference being that the conflict is disclosed, the disloyal act is not.

What might be the disloyal act? I'm thinking that In re eBay, Inc. Shareholders Litigation, 2004 WL 253521 (Del. Ch. 2004), may come into play here. During the late 1990s, a phenomenon known as spinning became common. In return for hiring a given investment bank to do their firm’s work, executives of that firm would receive preferential allocations of shares being sold in an IPO by another client of that investment bank. The executives would then sell those shares almost immediately, typically at a much higher price than then IPO sale price. Spinning thus apparently accounted for at least some of the persistent problem of under-pricing of IPO stocks.

The individual defendants here were executives of eBay who spun shares sold to them by Goldman Sachs. Plaintiffs are shareholders of eBay, suing derivatively. Plaintiffs advance the clever argument that the executives usurped a corporate opportunity from eBay.

Did Sokol's buying up shares in Lubrizol likewise usurp an opportunity he should have left on the plate for Berkshire-Hathaway? I think it would be a very aggressive application of the doctrine. But in the course of his opinion Chancellor Chandler further explained that "even if one assumes that IPO allocations like those in question here do not constitute a corporate opportunity, a cognizable claim is nevertheless stated on the common law ground that an agent is under a duty to account for profits obtained personally in connection with transactions related to his or her company." Granted, making a profit on inside information differs from the kickbacks at issue in eBay, but doesn't prompting your firm to buy a company in which you've invested similarly invoke fiduciary obligations?

In Brophy, the defendant insider traded on the basis of information about a stock repurchase program the corporation was about to undertake. Stephen M. Bainbridge, Securities Law: Insider Trading 20-21 (2d ed. 2007). In a very real sense, the insider was competing with the corporation, which both agency law and corporate law clearly proscribe. Indeed, the insider’s conduct in fact directly threatened the corporation’s interests. If his purchases caused a rise in the stock price, the corporation would be injured by having to pay more for its own purchases. A derivative suit seeking redress for that potential injury thus was quite proper.

In Toll, the Court defined a Brophy claim as follows:

“[A] plaintiff seeking to prevail on a Brophy claim ultimately must show that: 1) the corporate fiduciary possessed material, nonpublic company information; and 2) the corporate fiduciary used that information improperly by making trades because she was motivated, in whole or in part, by the substance of that information.” In re Oracle Corp., 867 A.2d 904, 934 (Del. Ch. 2004) (hereinafter “Oracle”), aff’d, 872 A.2d 960 (Del. 2005) (TABLE).

Toll, slip op. at 16.

If Sokol's trades drove up the price of Lubrizol, perhaps a Delaware court would extend Brophy to misappropriation cases? Indeed, a Delaware court might not even require a showing that the trades effected the price of Lubrizol stock. The Toll Court explained that:

In the typical scenario in which an insider trades based on material information that allegedly was not disclosed to stockholders, a corporation can recover for actual harm causally related (in both the actual and proximate sense) to the breach of the duty of loyalty. Without limiting the types of harm that could be related causally to a loyalty breach, the obvious candidates are costs and expenses for regulatory proceedings and internal investigations, fees paid to counsel and other professionals, fines paid to regulators, and judgments in litigation.

What all this shows, I think, is that the case stretches the boundary of insider trading liability. The misappropriation theory requires that you use information that belongs to the principal. Could one construct an argument based on corporate opportunities, agency law, Brophy and Toll that Sokol's information belonged to Berkshire-Hathaway? I've tried to play around with that in the preceding paragraphs, but I remain unpersuaded that there is a violation of federal law here.

Finally, Larry asks:

My question: what should federal law have to do with all this? The “hook” for federal securities liability is the trading in Lubrizol — but the breach of duty that triggers liability has to do with the details of Sokol’s dealings with Buffett and Berkshire. This, as I’ve said before, is appropriately a matter of state law. See my article, Federalism and Insider Trading, 6 Supreme Court Economic Review, 123 (1998).

A fair question, but one that I think has a good answer. I addressed this point at length (pp. 39-45, 83-84) of The Law and Economics of Insider Trading: A Comprehensive Primer, and even more length in Incorporating State Law Fiduciary Duties into the Federal Insider Trading Prohibition, 52 Washington and Lee Law Review 1189 (1995).

I argue that insider trading is not defined in the federal securities statutes. Instead, its definition has evolved through a process of common-law adjudication. At the core of the resulting rule is a requirement that the alleged inside trade constitute a breach of the trader's fiduciary duty to refrain from self-dealing in confidential information. Once the substantive definition of insider trading is viewed as a species of federal common law, the question arises whether federal courts should incorporate state law as the rule of decision or create a unique federal standard. I demonstrate that the insider trading prohibition can be justified only as a mechanism for protecting property rights in information. As such, the prohibition has relatively little to do with the traditional securities regulation concerns of disclosure and fraud. To the contrary, insider trading became a matter of federal concern because of the SEC's self-interest and that of some of its regulatory constituents. To be sure, the exigencies of detecting and prosecuting insider trading warrant a continuing federal regulatory role. Because there is no significant federal policy interest at stake, however, there is no reason to create a unique federal rule defining insider trading. Instead, courts should adopt state law fiduciary duty principles as the rule of decision.

Granted, reliance on state law will complicate insider trading prosecutions. But no more so than in any other case where state standards are incorporated into federal common law. In any case, there are affirmative reasons to adopt state law as the rule of decision. By acknowledging that insider trading is primarily a matter for state law, like all other questions of fiduciary duty, this approach accords proper deference to the states' position as the primary regulator of corporate governance questions. Finally, because state law fiduciary duty rules are designed to protect property rights, looking to them to define insider trading will more clearly tie the prohibition to the rationale for regulating insider trading.